Thursday, March 21, 2019

Fundraising Startups and their Associated Persons - Can They Be Broker-Dealers?

Continuing with the theme of broker-dealer registration, I now switch to the issuer safe harbor.  As you know, a broker is "any person engaged in the business of effecting transactions in securities for the account of others."  The key phrase here is "for the account of others".  Since many startup companies cannot attract the attention of broker-dealers to help them secure funding, the companies do it themselves.  Raising funds on the company's own behalf is not considered to be a broker-dealer activity.  However, even if the issuer itself is not a broker, anyone working for it may be because they would be selling securities of the issuer for the account of the issuer, not their own.  This brings into question the fundraising activities of issuer associated persons: its partners, officers, directors or employees. Note that Rule 3a4-1(c)(1) definition of "associated persons of the issuer" does not include independent contractors.

Whether such persons have to register as broker-dealers depends on facts and circumstances of each case.  In 1985, the SEC adopted Rule 3a4-1 that acts as a narrow nonexclusive safe harbor for associated persons.  Complying with the requirements of this Rule means that such associated person will not be required to register as a broker-dealer while engaging in fundraising activities.  First, the person needs to meet all three general requirements:
  1. Not be subject to a statutory disqualification at the time of his participation; AND
  2. Not be "compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities"; AND
  3. not at the time of his participation be an associated person of a broker or dealer (ie, its partner, officer, director or employee).
With respect to the second requirement, the SEC noted in the Proposing Release that "This prohibition is intended to preclude compensation arrangements which vary with or depend upon the success of the sale efforts by associated persons."  This does not seem to prohibit compensating the associated person for the participation in the capital raise but precludes varying the amount of compensation based on the amount raised.  One needs to be very careful with structuring the compensation of persons engaged in fundraising for the company.

If the three general conditions are satisfied, the associated person then needs to meet one of the following three criteria:
  1. Participate only in transactions involving offers and sales of securities to institutional investors, including broker-dealers, banks, investment companies or in connection with mergers, asset sales or certain other transactions (not really applicable to startups) - Rule 3a4-1(a)(4)(i)(A, B, C, D); OR
  2. Limit activities to (i) preparing written offering materials subject to approval by a partner, officer or director of the issuer, while not engaging in oral solicitation, (ii) responding to investor inquiries, provided that responses are limited to information in the offering document, or (iii) ministerial and clerical work in effecting the transaction; - Rule 3a4-1(a)(4)(iii); OR
  3. Perform (throughout the offering or starting at the end of the offering) substantial duties on behalf of the issuer other than marketing the securities, provided that this person is not a broker-dealer or its associated person within the prior 12 months and does not participate in the sale of securities of the issuer more than once every 12 months - Rule 3a4-1(a)(4)(ii). 
The issuer's founders, directors, officers, and employees would most likely rely on the third criterion when raising capital for their company.  However, it is important to remember that such fundraising efforts cannot happen more than once every 12 month period and that their compensation cannot depend on the success of their fundraising activities.

As I previously mentioned, this Rule is a nonexclusive safe harbor.  However, it is difficult to judge what activities would be permissible if you step outside of the strict confines of the Rule.  The SEC has repeatedly brought actions against associated persons of the issuers for failure to register (although often in connection with other charges such as fraud).

In conclusion, all startup founders should carefully structure their fundraising efforts so that their team is not deemed to be unregistered broker-dealers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Tuesday, March 12, 2019

International Brokers - Do They Have to Register with the SEC?

Due to the globalization of business dealings, issues often arise with respect to the proper registration of foreign persons as "brokers" or "dealers" under the U.S. federal securities laws (colloquially referred to as "broker-dealers").  Sometime, it is a U.S. person soliciting outside of the United States.  Other times, it is a non-U.S. resident who may be reaching out to the U.S. persons.  Below is a brief analysis of how the U.S. federal registration requirements apply to such international brokers.

First, the basics.  Section 15(a)(1) of the Securities Exchange Act of 1934 (the "Exchange Act") makes it unlawful for any "broker" or "dealer" to use interstate commerce to "effect any transactions in, or induce or attempt to induce the purchase or sale of, any security." The term "broker" is defined in Section 3(a)(4) of the Exchange Act to mean any "person engaged in the business of effecting transactions in securities for the account of others." Through numerous no-action letters, we know that the hallmarks of broker activity are: solicitation of potential investors, negotiation of deal terms, handling securities and/or funds, settling transactions, and receiving compensation that is tied to the success of the offering.  Further, the courts look at whether this person is "in the business" of doing so, i.e., certain degree of regularity.

There are several exemptions to the registration requirements for municipal securities brokers, government securities brokers, associated persons of the issuer (more on this in the next blog post), and online investment portals.  There is also a narrow common law exception for "finders" that with time has become so narrow that I am not certain it still exists.

B-Ds located in the U.S.

The approach with respect to broker-dealers that are located in the United States but work only with foreign investors is unsettled.  The SEC's general position was to require registration of broker-dealers physically located in the United States even if their activities were only directed at foreign investors located outside of the United States.  This broad extraterritorial approach was limited by the U.S Supreme Court holding in Morrison v. National Australia Bank Ltd. in 2010, that held that Section 10(b) of the Exchange Act only applied to conduct in connection with the domestic securities transactions (note that the case was about a different section of the Exchange Act, but courts later extended the analysis to broker-dealer registration provisions).  In particular, the Court held: "When a statute gives no clear indication of an extraterritorial application, it has none."

Section 929P of the Dodds-Frank Act, enacted into law less than one month after the Morrison decision, supported the SEC extraterritorial approach by amending the Securities Act and the Exchange Act to provide that the U.S. courts have jurisdiction over "(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors, or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States."   However, certain courts still applied the Morrison approach where the matters required interpretation of U.S. securities laws.  For example, in SEC v Benger (2013), the court held that the broker-dealer registration requirements did not apply to a person located in the United States that solicited foreign investors to invest into foreign securities.  It was unclear how to reconcile the Morrison case with the Congressional intent until the Tenth Circuit's decision in SEC v. Charles D. Scoville and Traffic Monsoon LLC that just became available in January 2019.  The heart of the case was the SEC civil enforcement action against defendants running a worldwide ponzi scheme.  The Court affirmed that the SEC correctly used the conduct-and-effects test to reach a securities transaction outside of the United States.  So, while the conduct-and effects test brought back by the Dodd-Frank Act will be used in governmental actions, as stated here, private actions under the antifraud provisions will continue to be governed by the Morrison test.  Another great analysis that supports the above can be found here.

Foreign B-Ds located outside of the U.S.

Foreign brokers that operate outside of the United States generally have to register with the SEC if they use any interstate commerce to effect securities transactions with persons in the United States.  This would include the use of the Internet and advertising materials.  There are, however, several significant exceptions for this general rule codified in Rule 15a-6 under the Exchange Act.

Although repeating the entire Rule here is beyond the scope of this blog post, I would like to draw your attention to several of its provisions.  The first one exempts from registration requirements those foreign broker-dealers that engage in "unsolicited transactions" in the United States.  As the SEC clarified in its FAQ (Question 9), there could be more than one such transaction. However, the focus should be on the foreign broker-dealer activities to determine whether solicitation had occurred.  The SEC warned that it interprets "solicitation" broadly to include phone calls encouraging use of such broker-dealer's services, advertising materials, and trading recommendations.

Another exception allowed foreign broker-dealers to forego registration in the U.S. for direct solicitation of securities transactions (and the effecting of such transactions without involving a U.S. broker-dealer) so long as such  solicitations were directed at foreign persons temporarily present in the United States.  The SEC noted in FAQ Question 1 that, although the question of "temporary presence" was a factual one, it was the overall intention of the SEC to exclude from the registration requirements those foreign broker-dealers who effected transactions with a foreign person located in the U.S. with whom they had a "bona fide, pre-existing relationship before the foreign person entered the U.S., so long as such person: (1) is not a U.S. citizen and (2) is not a lawful permanent resident of the U.S. (i.e., a “Green Card holder”)."

There are several more exemptions included in the Rule that are beyond the scope of this summary blog post.

In conclusion, as you can see, the broker-dealer registration requirements are quite complex as they apply to foreign broker-dealers soliciting and effecting transactions with U.S. persons or on U.S. soil.  Foreign broker-dealers, whether they are in the U.S. or not, should carefully consider application of the U.S. securities laws to their broker-dealer activities as they interact with their clients.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  


Thursday, November 8, 2018

Operating an Unregistered Digital Tokens Exchange is Unlawful

It didn't come as a surprise that the SEC today published an order announcing a settlement of charges it brought against Zachary Coburn, the founder of EtherDelta, a digital token trading platform.

The SEC has in the recent past brought charges against token issuers for failing to register their token offerings or comply with an available exemption, as well as against platforms for failing to register as broker dealers.  I previously wrote about them here and here.  Today's SEC order is long overdue but is much needed.  It sends a clear signal to the crypto industry that it is not outside of the existing regulations and that all crypto industry participants will be regulated to the extent required by the existing laws.  The crypto exchanges should register just like the traditional exchanges or operate pursuant to an available exemption.

Beginning in July 2016, EtherDelta provided a platform for trading Ether and various digital tokens (about 50), as well as a smart contract that ran on the Ethereum blockchain that was coded to validate the order messages, confirm trade order terms and conditions, execute orders, and update the distributed ledger to reflect the trade.  The website resembled an online securities trading platform.  Users could enter orders to buy or sell specified quantities of any token at a specified price.

The platform continued its operations even after the SEC's DAO Report that was issued on July 25, 2017, where the SEC advised that a platform that provides secondary trading in digital tokens that are securities is required to register with the SEC as a national securities exchange (or be exempt from such regulations).

Although Zachary Coburn posted on Reddit that "his platform function[ed] just like a normal exchange]", it was "decentralized ... Centralized exchanges won't be able to show you verified business logic [in a publicly verified smart contract]".  The decentralized nature of the exchange is not a new argument.  Many of our prospective clients (which never became real clients) claimed that their contemplated crypto exchanges did not need to register due to their decentralized nature. 

Section 5 of the Securities Act prohibits any exchange from effecting any transaction in a security unless registered with the SEC as a national securities exchange or operates pursuant to an exemption.  An "exchange" is defined in Section 3(a)(1) of the Exchange Act (and also the Exchange Act Rule 3b-16(a)) that say that an exchange is "any organization, association, or group of persons, whether incorporated or unincorporated, which .... provides a market place or facilities for bringing together purchasers and sellers of securities...".  One of the exemptions is for alternative trading systems (ATSs) that comply with Regulation ATS (they must, among other things, be registered as broker-dealers, file Form ATS with the SEC, and establish written safeguards and procedures for protecting users' confidential trading information).

The SEC found that "EtherDelta operated as a market place for bringing together the orders of multiple buyers and sellers in tokens that included securities" without registration or exemption, regardless of its decentralized nature.  The SEC also found Coburn to be an active and integral part of EtherDelta who exercised complete control over its operations.

I assume that EtherDelta was never registered as a legal entity.  However, its digital decentralized nature did not prevent the SEC from charging Coburn, the man behind the platform, for operating an unregistered exchange.       

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.